The best things in life may well be free, but the world remembers Motown Records’ first hit song, from summer 1960, for what comes next: “But you can give them to the birds and bees. I want money.” Sixty years later, little has changed – the bills keep coming and the only answer is still cash in the bank.
But where to get it from? Over the past decade, this has become an increasingly tricky problem for those who look to the financial markets to provide their income. Safe, steady cash flows from bonds have slowed to a trickle and many have turned to dividends from equity income funds to keep the money rolling in.
There’s nothing like a steadily rising income to keep investors smiling, and dividend-paying companies have done their best to oblige since the financial crisis. In 2009, UK companies paid out around £52bn in regular dividends (ignoring ad hoc special payments). Last year, Link Asset Services’ UK dividend monitor Q3 2019 estimated the equivalent figure will be £99.1bn. That’s an annual growth rate of more than 6% – not bad for an 11-year period during which inflation has stayed well below that level (and during most of 2015 was close to zero) and economic growth has rarely been above 2%.
Milking the portfolio In many ways, dividends are the main point of investing. Academic research has shown that a large proportion of the long-term total return that equity owners receive is accounted for by reinvesting dividend income to buy more shares, expanding their stock of capital from which to reap dividend income. Among equity income investors, the idea is different: they aim to milk the portfolio judiciously for regular income. Companies that aim to increase their dividend pay-out annually, ideally above the rate of inflation, are particularly sought after as other sources of income dry up.
Bullish investors will argue that the huge difference between gilt and dividend yields must indicate that bonds are outrageously expensive and shares excessively cheapBut as the post-crisis yield drought has dragged on, the risks for equity income investors have increased. Their implicit assumption – that a small group of large, mature companies can carry on indefinitely increasing their dividend payments above the rate of both inflation and GDP growth – has become steadily less safe. The current, yawning gap between the ‘risk-free’ yield on ten-year gilts, at around 0.75%, and the prospective 4.5% yield on the FTSE 100 Index, highlights the dangers building up.
Bullish investors will argue that the huge difference between gilt and dividend yields must indicate that bonds are outrageously expensive and shares excessively cheap. As this anomaly corrects, rising share prices will cause their dividend yields to fall, bringing the gap with gilts back towards its long-term average. That’s perfectly possible, but for share prices to rise, investors need to believe companies’ dividends are sustainable and their growth prospects solid.
Financially stretched firms This is open to question. As companies have attempted to meet investor expectations of relentlessly increasing dividend pay-outs, they have become financially stretched. UK companies’ dividend cover (the extent to which their earnings exceed their dividend payments) fell to 1.6x in 2019 – the third lowest ratio globally and far below the global average of 2.2x, itself a ten-year low, according to the asset manager Henderson. As UK companies have paid out a bigger percentage of their net profits as dividends, some have seen their cover ratio sink below 1x. With their margin of safety gone, many have taken on debt to help meet their payments. In ‘Avoiding dividend risk – Imperial Brands’, an opinion piece on fund manager Liontrust’s website, its global equity team head, Robin Geffen, says, “The average yield across the [equity income funds] sector is 4.4%, which appears attractive, but 25% of that yield is powered by companies that have uncovered dividends.”
If the economy goes into a downturn, many of these companies’ earnings will suffer and they will have to cut their dividendsThe 14% collapse in the pound after the Brexit referendum helped underpin the corporate world’s sterling dividend payments by increasing the relative value of their foreign earnings. This gave a final push to the dividend bandwagon, supporting increases in headline payments even as the underlying picture grew weaker. In Q3, says Link, regular dividends fell 0.2% year-on-year to £32.2bn, but it adds, “Even this total was inflated by £850m of exchange effects” thanks to the weak pound. For 2019 as a whole, Link predicted regular dividends would rise 3.3%, “almost nine-tenths of which is down to exchange-rate gains”.
The dangers are clear, whatever happens from here. If the economy goes into a downturn, many of these companies’ earnings will suffer and they will have to cut their dividends. And even if we escape a downturn, a boost to sterling will wipe out the currency gains that dividend payers have come to rely on.
This year looks like a tricky one for equity income funds and their investors.
This article was originally published in the February 2020 print edition of The Review.
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